Thursday, July 6, 2017

Pollyanna

In case you stay up at night worrying about the next financial crisis, the good folks at the Financial Stability Board have produced a nice soothing little video (original link in case the embed doesn't work, and so you can see that no, I'm not making this up),

The short summary:

Safer, Simpler, Fairer

3 July 2017

A decade on since the start of the global financial crisis, G20 countries have rebuilt the financial system so that it serves society, not the other way round.

By fixing the fault lines that caused the crisis, the financial system is now safer, simpler and fairer than before.

View and share our videos that explain the G20's work to reform the financial system.

As cheery propaganda, it's not quite up to the Chinese "belt and road" video standard, but pretty good. It needs more puppies and singing children. As unintentional humor, it scores highly. I mean, wasn't "safer" enough, questionable as it is? Did they really have to stretch for simpler and fairer? I don't think Dodd and Frank themselves buy that one. As a good link to have around for the next financial crisis, better still. As an insight into the wisdom of the Financial Stability Board... well, sometimes I find things that leave even me sputtering to find a pithy summary. You'll have to enjoy it on your own, and try to come up with something good in the comments.

Update: Look at the "capital" bucket. What capital ratio is in the video? What capital ratio is in real life?

The graphic comparing "Shadow Banking" with "Resilent Market Based Reform" depicts two bar graphs denominated in Trillions of dollars.

As for the 10X more capital than before:

https://fred.stlouisfed.org/series/DDSI05USA156NWDB

From 1999 to 2013, the bank capital ratio in the US jumped from about 12.25% to about 14.5%. My guess is that this is all capital (Tier 1 and Tier 2). The St. Louis Fed does have a graphic for just Tier 1 capital in the U. S. banking system.

The important part of Basel III was the introduction of a leverage ratio (not mentioned in the short graphic).

"Basel III introduced a minimum leverage ratio. This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items). The banks are expected to maintain a leverage ratio in excess of 3% under Basel III."

The difference between the "Capital Ratio" and the "Leverage Ratio" is two-fold:

1. With the Capital Ratio, the when sold (not market value) of equity is used. With the Leverage Ratio, the market value of equity is used.

2. With the Capital Ratio, the risk weighted value of assets is used. With the Leverage Ratio, the non-risk weighted value of assets is used.

The reason is this:With the Capital Ratio we are measuring the sensitivity of the bank to changes in the credit risk of its assets and how much loss can shareholders be expected to absorb.

With the Leverage Ratio, we are measuring the sensitivity of the bank to changes in it's own credit risk. The Leverage Ratio is an important measure because a bank that relies heavily on short term borrowing becomes susceptible to changes in short term interest rates.

A bank that has a high Capital Ratio can still run into trouble if it has a low Leverage Ratio. For instance, picture a bank that only buys U. S. government debt. By Basel III accounting rules (0% credit risk on government debt) its CAR is infinite - no matter the bank's debt / equity mix.

But if a bank funds the purchase of that government debt with 90% short term debt and 10% equity, then a 10% rise in short term interest rate conceivably wipes out shareholders even though the credit risk of the assets held by the bank has not changed.

This is another great example of "technocratic illusions", as you referred to in your previous post.

My impression is that policy makers behave like that not because they truly believe on it. If they are honest and say "hey, we are not really sure but we really think this will help based on our experience and research", then it will be very easy to make opposition. So from climate change policies to financial regulation they always act as they are 100% certain of everything. And I am not saying the policies are necessarily bad, many times they are not.

Independent of the reasons, being dishonest regarding our knowledge is not the way to go. I feel really bad, specially as a Fed economist, to see independent agencies spreading propaganda, literally behaving as politicians and not the technocrats they are supposed to be. And if they behave like politicians, why should the public believe they are in fact technocrats and not political groups? For example, after seeing a video like this, I would not take seriously an assessment by the FSB of the financial choice act.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!